Treatment of capital gains tax on change of status. (tax implications of changing property status from rental to principal residence)

by Schulz, Diane K.

Abstract- An overview of the capital gains tax implications when changing the status of a property from a rental dwelling to a primary residence dwelling indicates that the change is treated as a sale of the property, making capital gains deferment subject to a mandatory waiting period. If a residence is sold and replaced with a new one, the total capital gain during the ownership can be deferred as a reduction of the cost of the new residence if the owner lived there for two years following the sale, and the new residence is bought within two years after the sale. If the conditions are not met, the entire capital gain is considered ordinary income for taxation purposes.

During ownership, a property ma be used as a rental property or as a
principal residence. Capital gains tax implications upon a change in
status of the property from rental property to principal residence are
the focus of this article.

As a Rental Property

As a rental property any gain on sale must be treated as ordinary
income regardless of the length of holding period and whether it is the
first sale or a subsequent sale (except for the exchange of like-kind
assets). That is because rental property is treated as a business asset.

On the other hand, as a principal residence, the gain on the sale is
not recognized as long as the next purchase of a residence is made
within two years after the last sale, except for the case where the
adjusted sale price of the old residence exceeds the cost of the new
one. In such a case, capital gain is recognized to the extent of this
excess Sec. 1034(a). The non-recognized capital gain on the old
residence is deferred to serve as a reduction of the cost of the new
one, but this reduced cost of the new residence must not be lower than
the cost of the old residence. This treatment is always true no matter
how long the old residence had been held.

If the owner of a principal residence acquired a new residence within
two years after the sale of the old residence, the capital gain on the
first sale can be deferred. However, if this taxpayer again sold the new
residence less than two years after the first sale, and purchased a
third residence, the capital gain between the price of the second sale
and the cost of the new residence can no longer be deferred to serve as
a reduction of the cost of the third residence. However, the capital
gain on the first sale for the difference between the price of the first
sale and the cost of the old residence can still be deferred to serve as
a reduction of the cost of the third residence Sec. 1034(d). The only
exception to this rule is the situation where the second residence was
sold due to employment relocation. The two-year waiting time does not
apply to the first sale. In other words, the homeowner can own a first
residence for less than two years, sell it and replace it, and is still
entitled to the deferral of capital gain.

Example: Mr. Jones purchased residence No. 1 on January 1, 1980 for a
cost of $100,000. On July 1, 1980 he sold residence No. 1 for a price of
$110,000. On August 1, 1980 he purchased residence No. 2 for a cost of
$130,000. On February 1, 1981 he sold his residence No. 2 for a price of
$160,000. On March 1, 1981 he purchased residence No. 3 for a cost of
$200,000. What is the taxable capital gain in 1980 and 1981,
respectively? And what is the basis of residences No. 2 and No. 3
respectively? See Figure 1.

The taxable capital gain in 1980 is zero because the entire $10,000
gain ($110,000 - $100,000) is deferred even though Mr. Jones owned his
residence No. 1 for less than two years. As a result, the basis of
residence No. 2 is $120,000 ($130,000 - $10,000). The total accounting
capital gain on the sale of residence No. 2 in 1981 is $40,000 ($160,000
- $120,000). However, since he waited only seven months (from July 1,
1980 to February 1, 1981) which is less than the required two years of
waiting period after the first sale (July 1, 1980), the $30,000
($160,000 - $130,000) capital gain on the sale of residence No. 2 cannot
be deferred. The $10,000 capital gain on the sale of residence No. 1 can
be deferred. As a result, the taxable capital gain in 1981 is $30,000
($40,000 - $10,000). The basis of residence No. 3 is $190,000 ($200,000
- $10,000).

If, during the period of ownership, the status of principal residence
was changed to the status of rental property, and the property was
thereafter sold, the total capital gain throughout the entire ownership
period must now be treated as ordinary income regardless of how long the
property has been owned in either status (1988 Publication 523). If the
status of the property is changed in this way, the taxpayer is treated
as voluntarily giving up rights of capital gain exclusion for the
principal residence. The tax benefits of capital gain nonrecognition for
residence have been forfeited. Since this is ordinarily disadvantageous,
it should only be done after consideration of potential benefits.

Is The Reverse True?

If the status of the property was changed from rental property to
principal residence and the property was thereafter sold for a gain and
also replaced, can the taxpayer claim nonrecognition of the gain for the
residence? If so, an owner could reduce taxes by changing a rental
property to a principal residence shortly before it is about to be sold.
The capital gain on the rental property would be deferred.

As mentioned, for the taxpayer to be able to defer the capital gain on
the sale of a principal residence, there must be a wait of at least two
years from the date of purchase. The change of status from rental
property to principal residence is considered as a sale of the property.
Thus, the two-year waiting period becomes mandatory Sec. 1034(d).

If the status of a property has changed from rental property to
principal residence and this residence was thereafter sold and replaced
with a new residence, the total gain throughout the entire ownership
period can be deferred to serve as a reduction of the cost of the new
residence if the following conditions are met:

1. The owner has resided there for at least two years since the change
of status; and

2. A new residence is purchased within two years after the sale. If
any condition is not met, the entire gain must be treated as ordinary
income. Under any circumstances, the depreciation previously taken as a
rental property is always subject to recapture.

Example: On January 1, 1987 Mr. Smith purchased a house for a cost of
$100,000. He rented the entire house to a tenant and took depreciation
on the straight-line method for 27.5 years with $20,000 salvage value
for the land. On January 1, 1988 he terminated the lease with his tenant
and moved in with his family. On January 1, 1990 he sold this house for
a price of $150,000. On February 1, 1990 he purchased a new residence
for a price of $180,000. What is the taxable capital gain in 1990? And
what is the basis of his new residence?

This house must be treated as a rental property in 1987 and as a
principal residence thereafter. The depreciation taken in 1987 was
$2,909 ($100,000-$20,000)/27.5, and no depreciation thereafter. The
basis on January 1, 1990 when it was sold was $97,091 ($100,000 -
$2,909). Therefore, the total accounting capital gain was $52,909
($150,000 - $97,091). However, since Mr. Smith and his family have been
living there for two years since the date of change of status on January
1, 1988, to the date of sale on January 1, 1990, and the new house was
also purchased within two years on February 1, 1990, after the date of
sale, this $52,909 capital gain will not be recognized as ordinary
income in 1990. Instead, it will be deferred to reduce the cost of the
new residence. Therefore, the basis of the new residence on February 1,
1990 is $127,091 ($180,000 - $52,909). Had he sold the house on December
1, 1989, the total accounting capital gain of $52,909 would have been
treated as ordinary income in 1989 because it had been only 23 months
after the change of status, which is less than the required 24 months of
waiting period. The basis of his new residence would have been $180,000.

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